Level III SS3 essay quiz 1 solution

Level III SS Essay Quiz Solution (3 questions, 16 minutes) Topic: Behavioral Finance Minutes: 16 Part A Carolyn has a risk-seeking seeking (convex) utility function for gains and a risk risk-averse averse (concave) utility function for losses This is described by the Friedman-Savage Double-Inflection Inflection utility function with an inflection point where the function shifts from concave to convex This type of function explains why people may take low low-probability, high-payoff ayoff risks (e.g investing in venture v capital funds)) while at the same time insuring against low low-probability, probability, low-payoff low risks (e.g investing in TIPS) The concave portion of the utility function explains investing in low low-payoff TIPS,, while the convex portion of the function explains venture capital investments stments Traditional finance theory assumes risk aversion (concave utility function) at all levels of wealth, which would lead to rejection of all speculative investments having a negative expected return Template for Part B Discuss how Carolyn’s Behavioral bias behavior reflects each bias i Anchoring bias ii Overconfidence bias Explain how a rational economic individual in traditional finance would behave differently with respect to each bias Carolyn exhibits an anchoring bias as she has anchored a return of 20% in her mind and even when market conditions are not favorable, she is still not prepared to budge from her return objective A rational economic individual recognizes the prevailing economic ec and market conditions and takes the best decisions in light of the current circumstances cumstances and future forecasts so that an optimal investment plan can be achieved Carolyn exhibits an overconfidence bias as despite the recommendation of her investment advisor, she demonstrated unwarranted faith in her intuitive reasoning and judgment She turned down the advice based on very little research and trusted her cognitive abilities more than the information provided by the investment estment advisor A rational economic individual: • Should review his portfolio performance over at least two years so that not only does he recall the winners but also acknowledges all the losers which he picked based on his misguided belief in identifying identifyin a good investment • Should be objective when evaluating investments and should identify the reasons behind the results of investments so that they not lead to self-attribution attribution and overconfidence • Should perform a post-investment post analysis so that he can separate good decisions from bad ones Copyright © IFT All rights reserved www.ift.world Page Level III SS Essay Quiz Solution (3 questions, 16 minutes) Part C Hilton is incorrect that Carolyn’s portfolio allocation is inconsistent with the Mean-Variance Framework (MVF) and that it has elements of the Behavioral Portfolio Theory (BPT) An MVF investor constructs portfolios keeping in mind his risk tolerance, investment objectives and constraints, and circumstances Carolyn’s portfolio is mean mean-variance variance efficient as it incorporates all of these while also considering the relative correlation of returns be between tween different asset classes Hilton is also incorrect in classifying different asset allocations as layers because layers, referred to in BPT, are mutually exclusive and they not take into account the relative correlations between different asset classes sses Simply having bonds onds as an asset class does not categorize an investor as someone exhibiting mental accounting bias A traditional investor can be risk averse and allocate considerable fraction of his portfolio to Fixed Income Securities A BPT investor will have multiple attitudes towards risk depending on whic which h part of their wealth is being considered which is unlike traditional investors investors Copyright © IFT All rights reserved www.ift.world Page .. .Level III SS Essay Quiz Solution (3 questions, 16 minutes) Part C Hilton is incorrect that Carolyn’s portfolio allocation